ISSUES IN ACCOUNTING EDUCATION

Vol. 20, No. 1

February 2005
pp. 51–62

Activity-Based Costing and Cost

Interdependencies among Products:
The Denim Finishing Company
Dennis Caplan, Nahum D. Melumad, and Amir Ziv
ABSTRACT: A fictional example illustrates how interdependencies among products in
the production process, and the costs associated with those interdependencies, chal-
lenge the ability of cost accounting systems to generate decision-useful product cost
information. The cost interdependency in the current example is a production-line change-
over cost that is incurred to retool a machine whenever the production process changes
from one product to another. Both marginal costing and full cost activity-based costing
(ABC) are employed in an attempt to provide decision-relevant product-level information
in connection with the decision to add a new product.
Keywords: activity-based costing; cost interdependencies; product profitability analy-
sis; change-over costs; setup costs.

INTRODUCTION
The Morning Let-Down

D
iane Wiese, recently hired Marketing Director for The Denim Finishing Company, the first
person ever to hold that title, was not good at hiding her emotions. Whenever she felt angry
or embarrassed, her face turned red, and this morning, she was both. Two months ago, she
had left a mid-level marketing position at a large international apparel manufacturer to accept a top-
level position at this small contractor laundry, which provides laundering and finishing operations to
apparel manufacturers. She made the move because she liked the idea of being a big fish in a small
pond. She was also influenced by the enthusiasm and force-of-personality of the president and
principal shareholder, Tom Corcoran, who had started the company 15 years earlier.
Diane knew that Tom expected a lot from her, and she had anticipated that her announcement
this morning would be her first delivery on those expectations. She had proudly outlined in the
morning management meeting the details of a possible exclusive contract to provide laundering
operations for a well-known designer jeans company, Guess Who Jeans. The designers at Guess
Who Jeans had developed and patented a new process to give denim products a novel “distressed”
look. Thanks to Diane’s hard work, persistence, previous connections, and some luck, she was able
to convince the product manager at Guess Who Jeans that he should outsource the new finishing

Dennis Caplan is an Assistant Professor at Oregon State University, Nahum D. Melumad is a

Professor at Columbia University, and Amir Ziv is a Professor at the Interdisciplinary Center,
Herzliya, Israel.

We thank Wing Lam and Fred Tse of Levi Strauss & Co., Bjorn Jorgensen, Dennis Bline (associate editor), and two
anonymous reviewers for helpful comments and suggestions. We also thank Eyal Sulganik for using the case in the
classroom and providing feedback, and Galit Knaz and Mary Kay Reser for research assistance.

51
52 Caplan, Melumad, and Ziv

operation to Denim Finishing. However, Denim Finishing would not be allowed to offer the same
finish to any other customer. The company had never done work for Guess Who Jeans, so the
contract represented an important “foot-in-the-door.”
But now Bruce Farrand, the Operations Director for Denim Finishing, was questioning whether
the company even wanted the contract. The price per garment that Diane had negotiated with Guess
Who Jeans was $7.00. This was more than twice the revenue that Denim Finishing receives on any
other process. Diane attributed the high price not only to her bargaining skills, but to the fact that
Guess Who Jeans was known as a company focused on getting innovative, premium products to
market fast, and perhaps less focused on cost control than some of their competitors. Yet Bruce was
expressing doubts about the proposed contract. When they first met, Diane was favorably impressed
by Bruce. He was in his early fifties, seemed highly professional, and he had a low-key, friendly
demeanor, and a dry sense of humor. But now Diane was thinking to herself, “Did I misjudge him? Is
he one of those people who feels threatened by his co-workers’ successes? Or maybe he isn’t
ambitious enough to take on more work for more profits.”
Bruce had already emphasized that even though profit margins appeared high for the new finish,
volume would be relatively low. Bruce continued:
Their just-in-time program looks like a good idea—for them—not for us. They want us to drop
what we’re doing whenever they send us a shipment, and give them one day turnaround on small
batches. We don’t do that currently for our biggest and most loyal customers. We only have one
machine that can be retooled for Guess Who’s specialty finish, and that machine is already
running at capacity to provide stonewash finish, which we all know is selling like hotcakes. The
retooling costs and machine downtime that we’ll incur if we accept the contract will eat into our
profits. And since the specialty finish is patented by Guess Who, we can’t offer it to other
customers. Our experience with the new finish, and our efforts to overcome the learning curve,
won’t benefit us elsewhere.

When Bruce finished talking, all eyes turned to Tom Corcoran. Diane was prepared to respond point-
by-point to Bruce’s objections, but all of the joy had gone out of her morning.
Tom was quiet for a long time. Diane wondered whether this was “management by silence.”
Finally, Tom looked to Kelsey Bowser, the company’s Controller, and announced, “We have good
accountants and a good accounting system. Kelsey, can you incorporate Bruce’s concerns into
Diane’s proposed contract and estimate what the effect on our profits would be if we accept the
contract? Please try to have it ready by the end of the week.” Kelsey nodded, and the meeting moved
on to other business. After the meeting, Diane returned to her office. She wondered whether she
should offer to help Kelsey, but she barely knew Kelsey, and she reasoned that her offer might be
viewed as interfering. She decided to let things go, and see what Kelsey came up with on her own.

Background
The Denim Finishing Company provides laundering and finishing operations for large apparel
manufacturers. The company’s specialty is taking unwashed denim jeans and other denim products,
and finishing them with a stonewashed, rinsed, bleached, or other specialty finish. The garments are
then shipped back to the manufacturer for warehousing or distribution to customers. The company
does not manufacture or market garments, but rather provides an important service to apparel
manufacturers who want to outsource this part of the manufacturing process.
The company operates a single facility. Laundering operations are capital-intensive and require
a large investment in industrial-sized washing machines. The facility has six such machines, some of
which differ along technical specifications. The company operates three shifts daily to fully utilize
some of this equipment. One specialty finish is the “stonewashed” look, which is achieved by
washing garments along with pumice stone. Only one of the company’s six machines (Unit #4) can
be used for this process. At the present time, demand for stonewash by Denim Finishing’s customers

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Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company 53

exceeds the company’s capacity to supply this finish, so the company runs Unit #4 on all three shifts,
and some customers source this finish from other laundries as well.
Currently, Denim Finishing provides about a dozen different finishes to four major customers,
and also provides some of these same finishes to other customers that use the company occasionally.
Four years ago, management adopted an activity-based costing system. Most of the company’s costs
are overhead with respect to any one customer or type of finish, and profit maximization requires a
sound understanding of the cost of providing each finish, because prices are sometimes negotiable,
demand exceeds capacity on some equipment, and a variety of finishes are offered.

THE CONTROLLER’S ANALYSIS

Kelsey’s First Pass
In the afternoon on the same day as the meeting, Kelsey used Denim Finishing’s existing costing
system to assess the profitability of accepting the new order for the proprietary distressed finish. For
this analysis, Kelsey decided to ignore facility-sustaining costs and other costs that clearly don’t vary
with respect to the decision at hand. Following is the relevant information.

Operational Data for Unit #4

Capacity: the machine can run approximately 7,500 hours annually, using three shifts daily (a 9-
hour day shift, a 9-hour second shift, and a 6-hour night shift), six days per week (the facility closes
one day weekly, on a rotating schedule, and any required machine maintenance is scheduled for that
day). This assumes the machine runs only one finish, so there is no downtime retooling the machine
for a different finishing operation.
Batch time: three hours per batch, for both the stonewash and the proprietary distressed finishes.
This estimate includes time to load and unload Unit #4, but ignores materials-handling time that does
not tie up the machine.
Garments per batch: 100 garments per batch for both stonewash and the proprietary distressed
finish.
If Denim Finishing accepts the order from Guess Who, anticipated demand would be 100
shipments of the proprietary distressed finish, with 500 garments per shipment. This implies that five
consecutive batches of the proprietary finish would be processed on each of 100 days during the
year. Diane told Kelsey that she anticipates these shipments would be received on a schedule such
that no two shipments could be run back-to-back. Demand for stonewash is effectively unlimited, so
Denim Finishing could “fill in” on Unit #4 with stonewash whenever the machine was not used for
the proprietary process.
Revenue data: The revenue for stonewash is $2.00 per garment, and for the proprietary distressed
finish is $7.00 per garment.
Direct costs: Direct costs are effectively variable with respect to the number of garments processed.
Disposable supplies for stonewash consist of pumice stone, and for the proprietary distressed finish,
consist of a detergent and also an abrasive natural rock product. Shipping refers to the cost to ship the
garments back to the manufacturer. Stated on a per-garment basis, these direct costs are as follows:
Proprietary
Stonewash Finish Distressed Finish
Direct costs
Disposable Supplies $0.09 $0.90
Shipping $0.10 $0.20
Total $0.19 $1.10

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54 Caplan, Melumad, and Ziv

Overhead costs: The Denim Finishing Company classifies overhead costs into four cost pools,
based on the cost hierarchy of output unit-level costs, batch-level costs, product-sustaining costs, and
facility-sustaining costs.1
Batch-Level and Output Unit-Level Costs
Batch-level costs consist of utility expense and batch set-up costs for both washing and drying
operations. Output unit-level overhead costs consist of wages for materials-handlers. These materi-
als-handlers receive shipments of garments and batch them for processing. After the garments have
been processed through the washing and drying operations, the materials-handlers prepare finished
garments for shipment back to the customer. All batch-level and output unit-level costs have the same
resource requirements, stated on a per garment basis, for the proprietary distressed finish as for the
stonewash finish. This is partly due to the fact that batch sizes and machine cycle times are the same
for both processes. Batch-level and output unit-level cost information is as follows:

Overhead Cost
Cost Driver Overhead Rate per Garment
Batch-level costs
Utility expense machine hours $7.50 per hour $0.45
Set-up costs number of batches $25 per batch $0.25
Output unit-level costs
Materials handling number of garments $0.10 per garment $0.10
The per-unit utility expense is based on six machine hours per batch: three for washing and three
for drying. Hence, $7.50 per hour × 6 machine hours ÷ 100 garments per batch = $0.45 per garment.
Product-Sustaining Costs
Product-sustaining costs can be ignored for all processes other than stonewash and the propri-
etary finish (the two processes that utilize Unit #4). Product-sustaining costs for these two processes
are fixed costs that are incurred if that particular finish is run, and are avoidable if the finish is not
run. If the finish is run, then these costs are fixed, and do not vary with respect to the number of
batches or the number of garments per batch. Hence, the per-garment product-sustaining cost is an
allocation of fixed costs, and varies for stonewash depending on the number of units run.
Product-sustaining costs for stonewash are $140,000 annually. These costs consist of rental
payments on equipment to store and handle the pumice stone, and payments to a consultant who has
considerable expertise with the stonewash finish. The consultant supervises the quality assurance
process for stonewash, as well as sourcing of the pumice stone. The product-sustaining per-unit cost
depends on the volume of stonewash product, as shown in Exhibit 1.
Product-sustaining costs for the proprietary distressed finish are $37,500 annually, or $0.75 per
garment. These costs consist principally of monthly lease payments on equipment required to treat
the wastewater discharged from Unit #4 when the proprietary distressed finish is run on that
machine, before the wastewater can be released into the local sewer system. There are also annual
fixed costs for this finish that relate to regulatory permits for the wastewater discharge.
Facility-Sustaining Costs
These costs can be ignored, because they are expected to remain constant regardless of how Unit
#4 is used. Hence, they are not incremental costs with respect to the decision at hand.

1 For background information on the role of cost hierarchies in activity-based costing, refer to a comprehensive manage-
ment accounting textbook such as Cost Accounting: A Managerial Emphasis by Horngren et al. (2003), or Managerial
Accounting by Garrison and Noreen (2003).

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Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company 55

EXHIBIT 1
Per-Unit Product-Sustaining Cost for Stonewash

Per-Unit Product-Sustaining Cost for Stonewash, Using Unit #4 Only for Stonewash

7,500 machine hours available ÷ 3 hours per batch = 2,500 batches.

2,500 batches × 100 units per batch = 250,000 garments.
$140,000 ÷ 250,000 garments = $0.56 per garment. $0.56 per unit
Per-Unit Product-Sustaining Cost for Stonewash, Using Unit #4 for Both Finishes
Number of hours that stonewash cannot be run if the proprietary
distressed finish is introduced:
Run-time: 500 batches × 3 hours per batch = 1,500 hours
Machine change-over time (see discussion below) = 600 hours
Total hours: 1,500 + 600 = 2,100

7,500 hours available less 2,100 hours = 5,400 hours.

5,400 hours for stonewash ÷ 3 hours per batch = 1,800 batches.
1,800 batches × 100 units per batch = 180,000 stonewash garments.
$140,000 ÷ 180,000 garments = $0.777778 per garment. $0.777778 per unit

Machine Change-Over Costs

There are additional costs that Kelsey was unsure how to classify. These are costs associated
with converting Unit #4 between stonewash and the proprietary distressed finish, and they are in
addition to the usual batch-level set-up costs.
The change-over costs include shop-floor labor to clean and retool the machine. Bruce told
Kelsey that he would need two hourly workers for four hours each to perform these activities,
although the machine would only be down for three of the four hours. When Kelsey shared this
information with Diane, Diane thought it sounded very reasonable. Kelsey estimated the wage rate
for these two employees at $25 per hour. The change-over costs also include disposable supplies
(such as cleaning supplies) of $50 per change-over. Hence, the total out-of-pocket change-over costs
would be $250 ($25 per hour × 4 hours × 2 employees; plus $50 in supplies). These costs would be
avoided if Unit #4 were used for either finish exclusively.
In addition, there was an opportunity cost that Kelsey knew was relevant, but that the accounting
system would not normally incorporate. Unit #4 would require 3 hours of downtime whenever the
machine was retooled to switch from one finish to the other. Since three hours represented one batch
of product, running both products would reduce the total number of batches run on Unit #4 from
2,500 to 2,300 (100 conversions from stonewash to the proprietary finish, and 100 conversions back
to stonewash). Kelsey reasoned that the opportunity cost should be measured as the lost contribution
margin on sales of stonewashed product, and she calculated the contribution margin of one batch of
stonewash as $200 in revenue less $19 in direct costs, $10 in materials handling costs, and $70 in
batch-level costs, for a lost contribution margin of $101 per change-over.
These calculations result in an estimate of out-of-pocket change-over costs of $250 per change-
over and an opportunity cost of $101 per change-over. Therefore, Kelsey included $351 of machine
change-over costs as batch-level costs, and used the number of batches as the cost driver. In her notes
she summarized the overhead rate for change-over costs as follows:
Total change-over costs are $70,200, calculated as $351 per change-over × 200 change-overs.
Hence, the overhead rate per batch is $70,200 ÷ 2,300 batches = $30.5217 per batch, or $0.305217
per garment for both stonewash and the proprietary distressed finish.

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56 Caplan, Melumad, and Ziv

Treating change-over costs in this manner, Kelsey prepared the cost analysis for the two prod-
ucts that is presented in Exhibit 2. Kelsey included, for comparison purposes, the benchmark case of
using Unit #4 only for stonewash.

Kelsey’s Second Pass

When Kelsey completed the analysis in Exhibit 2 for running both stonewash and the propri-
etary distressed finish, she immediately suspected it was in error. Stonewash had always proven to be
a profitable finishing operation in the past, as illustrated by the stonewash-only benchmark scenario
in Exhibit 2. Kelsey quickly identified her problem as the way she had treated the change-over costs.
She now decided that these costs should be classified at the product-sustaining level, not the batch
level, since they relate to switching from one finishing process to the other, and are not incurred
when Unit #4 is running consecutive batches of the same finish. Although it was already late in the
afternoon, Kelsey revised the analysis, this time treating the change-over costs in the following
manner:
Stonewash:
$351 per change-over × 100 change-overs to the stonewash process = $35,100.
$35,100 total change-over costs ÷ 180,000 garments = $0.195 per garment.
Proprietary distressed finish:
$351 per change-over × 100 change-overs to the proprietary distressed finish = $35,100.
$35,100 total change-over costs ÷ 50,000 garments = $0.702 per garment.
Using these allocations for change-over costs, Kelsey’s revised cost analysis is shown in Exhibit
3. This revised analysis seemed more reasonable to Kelsey. The analysis indicated that when running
both processes, both were profitable, but the proprietary distressed finish was much more profitable
than the stonewashed process on a per-garment basis.
It was after 5:00PM by the time Kelsey showed this analysis to Diane, but Diane was eager to
review it immediately. They spent almost an hour going over it line by line, and Kelsey thought that
Diane asked a lot of good questions. Diane was pleased that apparently, she had gotten off on the
right foot with Kelsey. Diane told Kelsey that the analysis was consistent with her intuition. “I
suppose this doesn’t address all of Bruce’s concerns,” Diane concluded, “but it certainly supports
accepting the order and using Unit #4 for both stonewash and the proprietary distressed finish.”

Kelsey’s Third Pass

At 7:00AM the next morning, Kelsey was sitting in her office reviewing her notes for her
presentation in the upcoming meeting. She was feeling increasingly uncomfortable with her analysis.
Minutes before the meeting was to begin, she pulled Diane aside and told her that she needed another
day. Diane was surprised, but by now, she had confidence in Kelsey’s abilities, and she reasoned that
one more day would not make much of a difference. That afternoon Kelsey analyzed the problem
again, this time by calculating the marginal revenues and costs of accepting the new order. Her
analysis is presented in Exhibit 4.
First, Kelsey recorded the incremental revenue from accepting the order. This was easy: it was
just the $7 price per garment multiplied by the anticipated demand of 50,000 garments. Then she
subtracted the incremental out-of-pocket costs: the direct costs for supplies and shipping; and the
overhead costs for set-up, utility expense, materials handling, and product-sustaining activities. Then
Kelsey subtracted the out-of-pocket machine change-over costs ($250 per change-over multiplied by
200 change-overs). Finally, Kelsey subtracted the opportunity cost associated with the reduction in
sales of stonewash garments. Accepting the order from Guess Who Jeans results in lost sales of
70,000 stonewash garments (50,000 lost sales of stonewash garments due to machine-time process-
ing the new finish instead of stonewash, and 20,000 lost sales of stonewash garments due to machine
downtime when the machine is being retooled from one finishing process to the other).

Issues in Accounting Education, February 2005

 Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company
EXHIBIT 2 EXHIBIT 3
Product Profitability Using ABC and Treating Product Profitability Using ABC and Treating
Change-Over Costs as a Batch-Level Cost Change-Over Costs as a Product-Sustaining Cost

Both Products are Run

Stonewash Proprietary Proprietary
Only Distressed Distressed
Stonewash Stonewash Finish Stonewash Finish
Revenue per unit $2.00 $ 2.000000 $ 7.000000 Revenue per unit $ 2.000000 $ 7.000000

Direct costs Direct costs

Disposable supplies $0.09 $ 0.090000 $ 0.900000 Disposable supplies $ 0.090000 $ 0.900000
Shipping 0.10 0.100000 0.200000 Shipping 0.100000 0.200000

Product-sustaining costs Product-sustaining costs

Administration 0.56 0.777778 0.750000 Administration 0.777778 0.750000
Change-over costs 0.195000 0.702000
Batch-level costs
Issues in Accounting Education, February 2005

Batch-level costs
Utility expense 0.45 0.450000 0.450000 Utility expense 0.450000 0.450000
Set-up costs 0.25 0.250000 0.250000 Set-up costs 0.250000 0.250000
Change-over costs — 0.305217 0.305217
Output unit-level costs
Output unit-level costs
Materials handling 0.100000 0.100000
Materials handling 0.10 0.100000 0.100000
Total cost per unit $ 1.962778 $ 3.352000
Total cost per unit 1.55 $ 2.072995 $ 2.955217
Profit (loss) per unit $ 0.037222 $ 3.648000
Profit (loss) per unit $0.45 $ (0.072995) $ 4.044783

57
58 Caplan, Melumad, and Ziv

EXHIBIT 4
Marginal Cost Analysis of Accepting the Order from Guess Who Jeans

Revenue from the proprietary process $7.00 × 50,000 units = $350,000

Costs of the proprietary process
Direct Costs:
Disposable supplies $0.90 × 50,000 units = $45,000
Shipping $0.20 × 50,000 units = $10,000

Overhead:
Product-sustaining costs $37,500
Batch-level costs
Utility expense $22,500
Set-up costs $12,500
Output unit-level costs
Materials handling $5,000

Out-of-pocket change-over costs $50,000

Opportunity cost associated with the lost contribution
margin on sales of 70,000 stonewashed garments:
70,000 units × ($2.00 revenue less $0.19 in direct costs,
$0.10 in materials handling, and $0.70 in batch-level
costs) = $70,700 70,700
Incremental profit from accepting the new order $96,800

The marginal cost analysis presented in Exhibit 4 supported accepting the order from Guess
Who Jeans. Kelsey believed that this analysis validated the per-garment information provided by the
company’s activity-based costing system, and she told Diane that she would present the data in
the next day’s management meeting.
REQUIREMENTS
Review the Controller’s analysis and Exhibits 2 through 4, and complete the following
requirements.
1. Describe the machine change-over costs in terms of activity-based costing concepts. What
would you identify as the cost driver for these costs? Do you agree with the Controller’s ultimate
classification of these costs as product-sustaining costs? If not, how would you classify these
costs in the cost hierarchy?
2. What nonfinancial issues should be considered in connection with the decision of whether to
accept the order from Guess Who Jeans?
3. Put yourself in the role of Tom Corcoran. When Kelsey presents Exhibits 3 and 4 in the morning
management meeting, what questions will you ask? What decision will you make?
4. Discuss the reliability of activity-based costing to lead to the optimal (profit-maximizing) pro-
duction decision.
5. Do you agree with the Controller’s marginal cost analysis? Discuss the reliability of marginal
costing to lead to the optimal (profit-maximizing) production decision.

REFERENCES
Garrison, R. H., and E.W. Noreen. 2003. Managerial Accounting. 10th edition. Boston, MA: Irwin McGraw-
Hill.
Horngren, C. T., S. M. Datar, and G. Foster. 2003. Cost Accounting: A Managerial Emphasis. 11th edition.
Upper Saddle River, NJ: Prentice Hall.

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Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company 59

CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE

Overview of Learning Objectives
The primary learning objective of the case is to illustrate to students who are already somewhat
familiar with activity-based costing and marginal costing the conceptual complexities and challenges
that can be encountered when applying these techniques in practice. The case demonstrates that these
techniques cannot be relied upon to always lead to optimal decisions even when they are applied in a
seemingly correct manner. A secondary objective of the case is to prompt a discussion of the possible
trade-offs between short-term profit maximization and other marketing and management
considerations.
The case accomplishes its primary objective through three specific subobjectives. First, the
importance of cost interdependencies among products is introduced. The cost interdependency in
the current case is a machine change-over cost that is incurred when production is switched from one
product to another. As discussed in the Teaching Notes, such cost interdependencies can take many
forms, and are probably more prevalent in multi-product manufacturing settings than commonly
acknowledged in cost accounting textbooks. The second subobjective is to illustrate that costing
techniques cannot be relied upon to lead to optimal decisions consistently unless the manager’s
choice-set is correctly identified. The third subobjective is to highlight the importance of applying
costing techniques in the context of the decision at hand. In particular, the question of whether it is
appropriate to apply costs to the product level depends on the decision-context.
To accomplish these learning objectives, a fictional manufacturing company is employed. The
fictional company provides some sense of realism, and includes sufficient numerical complexity so
that few students will quickly identify the optimal profit-maximizing production decision. Neverthe-
less, some simplifying assumptions have been made to ensure that the case can be covered in a single
class session.

Implementation Guidance
The case has been used in the classroom eight times over three semesters, by two faculty in
undergraduate programs at two universities. Faculty have used the case in both introductory and
intermediate managerial accounting courses. Student feedback suggests that the case is more effec-
tive at the intermediate level. The basic idea that constitutes the core of the case—that both activity-
based costing and marginal costing can provide misleading product profitability information when
there are cost interdependencies among products—was used originally as a short case and exercise
by two of the authors in M.B.A. and Executive M.B.A. programs.
The case is intended to supplement, not substitute for, the typical textbook coverage of activity-
based costing and marginal costing. The case is best used after students have been introduced to
activity-based costing and marginal costing in sufficient detail so that they have a sense of confi-
dence in the reliability of these techniques to produce decision-relevant information and in their own
ability to apply these techniques. Typically, covering the material in the activity-based costing and
relevant cost chapters of any standard managerial accounting textbook constitutes strong back-
ground for the case. We suggest running the case in the final class session of the discussion of
activity-based costing, immediately after a more “traditional” activity-based costing case or lengthy
exercise in which activity-based costing provides the “correct” answer after traditional cost alloca-
tions have failed.

Student Reaction to the Case

Students in two sections of an undergraduate introductory managerial accounting course at one
university, and two sections of an undergraduate intermediate managerial accounting course at
another university, completed pre-case and post-case surveys. Students reported their self-assess-
ment of their understanding of activity-based costing and marginal costing both prior to and subse-
quent to the case, and they also evaluated whether the case was realistic, interesting, and beneficial.

Issues in Accounting Education, February 2005

60 Caplan, Melumad, and Ziv

This student feedback was anonymous.2 There are interesting differences between the two courses,
but few differences between the two sections within each course, so in our presentation of the survey
results, the sections are combined.
Table 1 reports students’ self-assessment of their knowledge of activity-based costing and
marginal costing before and after exposure to the case. Three questions were asked, two relating to
activity-based costing, and the third relating to marginal cost analysis.
As might be expected, the intermediate students indicated consistently higher levels of knowl-
edge than the introductory students, in both the pre-case and the post-case surveys. The responses of
the intermediate students to two of the three questions show a statistically significant improvement in
their knowledge of activity-based costing and marginal costing (using a one-tailed, paired t-test and a
5 percent significance level). However, the magnitude of the improvement is small (less than 0.5
points on the seven-point scale), and the students actually reported a decrease (although not statisti-
cally significant) in their perceived knowledge of how activity-based costing provides more accurate
information about product profitability than traditional costing. This should not be a surprise, insofar
as the case emphasizes the limitations of ABC analysis. Students who had already studied ABC
possibly realized that they previously had a false sense of confidence. In contrast to the intermediate
students, the introductory students report statistically and pedagogically significant increases in
knowledge on all three questions. The minimum improvement that they report is 0.88 on the seven-
point scale, and the maximum improvement is 1.28.

TABLE 1
Student Self-Assessment of Knowledge
Intermediate Course Introductory Course
n = 67 n = 63
Pre-Case Post-Case Pre-Case Post-Case
Mean Mean Mean Mean
For each of the topics below, rate
your level of expertise:
1. Your understanding of the 4.76 4.94 3.15 4.43
concepts and techniques used in
Activity-Based Costing, such as
the concepts of cost pools, cost
drivers, and cost allocation bases
2. Your understanding of how 5.06 5.00 3.70 4.58
Activity-Based Costing
provides more accurate
information about product
profitability than traditional
costing methods
3. Your understanding of the 4.37 4.79 3.52 4.56
concept of marginal cost,
and how to use marginal
cost analysis in a decision-making
context
Responses are based on a seven-point scale, with 1 = Novice and 7 = Expert.

2 In order to conduct a paired t-test comparing pre-case and post-case surveys, we requested students to indicate a “fictional
name” on the pre-case survey, and to use the same name on the post-case survey. This allowed us to match pre-case and
post-case surveys by respondent. Since the paired t-test could only be conducted on students who were in class both when
the pre-case survey was administered and when the case was discussed, for consistency, our discussion of student
feedback throughout this section is based solely on students who completed both surveys.

Issues in Accounting Education, February 2005

Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company 61

Table 2 reports students’ overall evaluation of the case. The intermediate students report higher
levels of satisfaction on all three questions than the introductory students, and also, there is less
variance in the responses of the intermediate students than in the responses of the introductory
students. In answer to the question of whether the case was beneficial, the introductory students were
mildly favorable (mean score of 4.57 on the seven-point scale, where 4 = Neutral), while the
intermediate students were somewhat more favorable (mean score of 5.46).
Considering the results reported in Tables 1 and 2, as well as qualitative responses that students
provided to open-ended questions asking what they liked most and least about the case, and whether
they found anything unclear or unrealistic, we interpret the student feedback as follows. The interme-
diate students, having covered marginal costing and activity-based costing in both an introductory
course and the intermediate course prior to the survey, considered themselves generally knowledge-
able in these areas, and rated themselves fairly highly in the pre-case survey. Hence, after the case,
there was comparatively little room on the seven-point scale for them to indicate improvement.
Furthermore, since the case is designed to increase student awareness of the complexity of applying
activity-based costing and marginal costing, the fact that many of these students were no more
comfortable with their level of knowledge of these concepts after the case than before does not
necessarily indicate that the case did not meet its objectives. The introductory students had much less
exposure to activity-based costing and marginal costing prior to the case, and so they viewed the case
as contributing significantly to their knowledge of these concepts.
In their overall evaluation of the case, the intermediate students were favorable, and signifi-
cantly more favorable than the introductory students. We believe that the intermediate students had
enough prior exposure to the traditional “textbook” view of activity-based costing to perceive the
value of the case. Also, in comparing the responses of the intermediate students to the introductory
students, there are two types of self-selection among the intermediate students that might help
explain the differences between the two groups. First, a larger percentage of the intermediate stu-
dents have chosen accounting as their intended career. Hence, they might be expected to have more
interest in the subject matter. Second, many of the intermediate students chose to take the course (i.e.,
it was an elective in their program of study), whereas all of the students in the introductory course
were required to take the course.
Overall, we conclude that the case is best used in intermediate or advanced managerial account-
ing courses or at the M.B.A. level.

TABLE 2
Student Evaluation of the Case
Intermediate Course Introductory Course
n = 67 n = 63
Standard Standard
Mean Deviation Mean Deviation
For each of the following statements,
indicate your level of agreement:
4. The Denim Finishing Case 5.43 1.10 4.59 1.66
provided a realistic context for
studying Activity-Based Costing
5. The Denim Finishing Case was 5.22 1.14 4.84 1.83
interesting
6. Overall, I think the Denim 5.46 1.12 4.57 1.97
Finishing Case was beneficial

Responses are based on a seven-point scale, with 1 = Disagree and 7 = Agree.

Issues in Accounting Education, February 2005

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